# Stock Swap

Stock swap transactions are one of the popular ways in which mergers can be financed. Stock swap refers to the situation when an acquiring company exchanges its common stock shares for common stock shares of the target company at the agreed upon ratio.

The ratio, which is called ratio of exchange, is determined during merger negotiations. The acquiring company often needs to repurchase shares in the market place to obtain an adequate amount of shares to be able to complete the stock swap transaction.

To find the ratio of exchange, the dollar amount required to be paid per share of the target company must be divided by the market value of the shares of the acquiring company.

Ratio of exchange = amount required to be paid per share of the target company/market value of the shares of the acquiring company

Test yourself:

ABC Company would like to acquire company BCD by using a stock swap transaction to finance the merger. ABC’s shares currently trade for \$60 per share. BCD’s shares are traded for \$55. However, in merger negotiations, it was agreed that BCD’s shares should be valued at \$90 per share. What is the ratio of exchange in this merger stock swap transaction?

Solution:

The ratio of exchange is 1.5 (90/60). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction where it will exchange 1.5 shares of common stock for each common stock share of BCD. ABC’s shares trade at \$60 per share. It was agreed during merger negotiations that BCD’s shares will be valued at \$90 each. The real market price of BCD’s shares is \$55 per share. Find out how many shares does ABC need to exchange in the stock swap transaction if BCD needs to obtain 15,000 shares?

Solution:

ABC needs 22,500 (15,000*1.5) to complete stock swap transaction with BCD at a ratio of exchange of 1.5:1.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s earnings before the merger were \$400,000 per year and it has 110,000 of shares of common stock outstanding. ABC will have to issue 22,500 shares of additional common stock to complete the stock swap transaction with BCD. BCD’s earnings before the merger are \$65,000 and it has 15,000 shares of common stock outstanding. The ratio of exchange is 1.5 of ABC’s shares for 1 share of BCD.

What are current earnings per share (EPS) of ABC and BCD and what will be the initial earnings per share of ABC after the merger, if earnings are assumed to stay unchanged?

Solution:

Current (before the merger) earnings per share (EPS) of ABC is \$3.6 (400,000/110,000).

Current (before the merger) earnings per share (EPS) of BCD is \$4.3 (65,000/15,000).

Initial earnings per share of ABC after the merger is:

= ((400,000+65,000)/(110,000+22,500))

=485,000/132,500

= \$3.5

It is common for earnings per share of acquiring company to initially decrease. This happens because acquiring company pays a large premium above the target company’s market price. In the long run, however, earning per share will likely be higher than it would be without the merger.

If the price/earnings ratio (P/E ratio) paid for the target firm by the acquiring firm is greater than the P/E of acquiring firm then, the EPS of the acquiring firm will initially decrease and vice versa. However, in the long term, the EPS of acquiring firm should increase. The P/E Ratio is found by dividing the market price per share by earnings per share (EPS).

Test yourself:

ABC (acquiring company) is acquiring BCD (Target Company) with the use of a stock swap transaction. ABC’s market price is \$60 and its earnings per share are \$3.6. BCD’s market price is \$55 and its earnings per share are \$4.3. However, during merger negotiations ABC agreed to a 1.5 ratio of exchange where it value BCD’s shares at \$90.

A. Explain how ratio of exchange was determined.

B. Calculate the P/E ratio for ABC and BCD before the merger at market prices per share.

C. Calculate the P/E ratio of BCD at the agreed upon price per share for the merger.

Solution:

A.

The ratio of exchange of 1.5 is calculated by dividing \$90 (the agreed upon price of BCD’s share) by \$60 (the market price of ABC’s share). ABC will need to exchange 1.5 shares of common stock to obtain 1 common stock share of BCD.

B.

P/E ratio of ABC before the merger is \$60/\$3.6=16.6

P/E ratio of BCD before the merger is \$55/\$4.3=12.7

C.

The P/E ratio of BCD at the agreed upon price per share for the merger is:

\$90/\$4.3=20.9

The P/E ratio paid by ABC for target company (BCD) was larger than the P/E ratio of ABC. This was due to an agreed upon price for BCD common stock shares which was \$35 (\$90-55) or 63.6% (35/(55/100)) above the  target company’s market price. It is common for an acquiring firm to pay approximately 50% above the target company’s market price. Consequently, in such situations the P/E ratio paid is often higher than the acquirers P/E ratio. This results in the initial earnings per share to be lower after the merger.

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# Establishing a dividend policy

Dividend policy refers to the policy which is used as a guide when a firm makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.

Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.

Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

# Factors which affect dividend policy

There are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints – this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Firm also cannot pay any part of par value of common stock. Sometimes, in addition to the inability to pay any part of par value of common stock, firm also may not pay any part of paid-in capital in excess of par.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negative signal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positive signal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Shareholders generally prefer fixed or increasing dividends. This decreases uncertainty and investors are likely to use lower rate at which earnings will be discounted. This will lead to an appreciation of share and an increase in shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

However, if the economy is growing very fast then the firm may have more acceptable investments to take advantage of. It can be best not to distribute dividends but rather use these funds for investments.

Changes in government policies and state of the industry must also be taken into account.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

If the firm will have to issue more stock to be able to pay out dividends than it may be in the best interest of the current stakeholders not to issue dividends to avoid potential dilution of ownership. Dilution of ownership occurs because after issuing of additional stock, retained earnings will have to be distributed over a larger amount of the shareholders. This leads to dilution of earnings for existing shareholders. This also leads to dilution of control.

Firms also need to consider the wealth level of the majority of its shareholders. If the majority of shareholders are lower income earners than they likely will need dividend income and will prefer payment of dividends. However, if the majority of shareholders are high income earners then they will likely to prefer appreciation of share as it will defer tax payment even if the tax applicable on dividends and capital gains is the same, as in US after 2003 Tax Act.

Interestingly, in an efficient market, preferences of the shareholders should be met by price mechanism. If dividend payments are lower than required by many investors than those investors will sell their shares. Share prices will drop and this will raise an investors’ expected return. Higher expected return will increase the weighted marginal cost of capital and intersection between IOS and WMCC schedules will occur at a lower optimal capital budget point. Due to higher WMCC, fewer of the projects will be acceptable and more of the retained earnings can be paid out as dividends. Therefore the owners’ preferences are satisfied by price mechanism.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.

Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

One of the reasons firms may want to pay dividends in years when the firm incurred a loss is to send positive signal to the market indicating that the loss is only a temporary phenomenon and that the company has its operations under control. Otherwise, shareholders may start selling shares which will decrease price of the shares and even further decrease wealth of the owners of the company (shareholders).

Lack of adequate cash and cash equivalents – occurs when firm do not have adequate cash and cash equivalents, such as marketable securities, to make dividend payments. Borrowing with intention to use funds to pay out dividends is usually not welcomed by lenders because the use of funds is not aligned with activity that would help firm to pay back debt to the lender. Borrowing to pay dividends is also usually not a wise business decision.

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# Higher dividends

There are factors that make higher dividends beneficial. For example, higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

It is also suggested that for investors to sell current stock to obtain income equivalent to dividends is not the same psychologically as receiving dividends. It is harder psychologically to sell stock to obtain income than to use dividends to obtain income. Therefore, it is argued, that these two actions cannot be viewed as substitutes, as proposed by the dividend irrelevance theory. The above point suggests that shareholders who need income that comes from dividends are psychologically more comfortable with receiving dividends than with selling part of their shares.

Another argument for the benefits of higher dividends refers to the fact that \$1 of dividends received now cannot be seen as equivalent to \$1 of future dividends or stock appreciation to be received at some point in the future.

Investors will prefer \$1 to be received now to \$1 to be received in the future. The only way they will be indifferent is if the amount to be received in the future will be adjusted to account for the time value of money.

Time value of money refers to the fact that investors will prefer \$1 today to \$1 tomorrow. For example, if an investor can receive \$100 today or a certain amount 1 year from now, the only way the investor will be indifferent is if the amount 1 year from now is larger by an equivalent to investor’s required return.

In other words, future dividends or share appreciation must bring benefit of \$1 plus additional return based on the required return of the investor. Only in such case investor will be indifferent. If investor’s required return is 9% per year than the investor will be indifferent if \$100 is received today or \$109 received in 1 year from now.

# Lower dividends

Transactions costs often make lower dividends more beneficial for stockholders and for the firm. It is more beneficial for a stock holder to have lower dividends if an investor intends to reinvest dividends in stock. This occurs because there are transactions costs that investor have to incur to buy stock such as brokerage fees.

The firm will benefit from paying lower dividends in the case where external financing is required. This is because external financing results in costs such as flotation costs. If firm just uses retained earnings available instead of paying out dividends then the costs of external financing will be avoided or decreased.

Tax that investors have to pay on capital gains is generally lower than tax that they have to pay on dividends (this, however, may differ depending on location of investors and is no longer applicable to US investors as a result of the 2003 Tax Act).

Moreover, tax on capital gains must only be paid in the future, when the gain will be realized. The tax on dividends must be paid when payment of dividends occurs. Therefore, from this perspective, it is generally more beneficial to reinvest earnings compared to paying it out as dividends to the shareholders.

Also, if investors want to reinvest dividends by buying more stock, investors still lose money by paying taxes on dividends. Therefore, an argument made by dividend irrelevance theory suggesting that investors can reinvest dividends by buying more stock and therefore obtaining the same result as by funds being reinvested is irrelevant as soon as assumptions of a perfect world (which includes the assumption that there are no taxes) is no longer hold.

# Operating Cash Inflows

Operating cash inflows is a second variable that we must take into account when determining cash flows from the project. It refers to incremental (additional) cash inflows over the duration of the project. The cash inflows do not take into account interest payments and are calculated as follows:

Revenue

LESS: Expenses (excluding depreciation and interest

= EBDIT (Earnings before depreciation, interest and taxes)

LESS: Depreciation

= EBIT (Earnings before interest and tax)

LESS: Taxes

= NOPAT (Net operating profit after taxes)

= OPERATING CASH INFLOWS

# How to calculate EPS (Earnings per Share)?

Calculating earnings per share (EPS) allows us to understand how much dollars were earned on each outstanding share of common stock.

In summary, in order to find earnings per share (EPS), we need to take earnings available for common stockholders (the bottom line of the income statement ) and divide it by number of shares of common stock outstanding.

Earnings per Share (EPS) = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding

Therefore, in order to determine EPS (earnings per share), we need to know earnings available for common stockholders. Earnings available for common stockholders are calculated as follows:

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

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